Elasticity and Its

Applications
5
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 Elasticity . . .
• Do you know about elastic?
• We know that buyers usually demand more of a good when its
price is lower / their incomes are higher
• when the prices of substitutes for the good are higher
• when the prices of complements of the good are lower.
• Elasticity: is a measure of responsiveness of quantity demanded or
quantity supplied to one of its determinants.
• Price Elasticity of Demand: is a measure of change in quantity
demanded of a good responds to a change in the price of that good.
OR it is the percentage change in quantity demanded in response to
percent change in the price.

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The Price Elasticity of Demand and Its
Determinants
Consumers move away from an expensive good when
•Availability of Close Substitutes e.g. butter and
margarine(elastic)
•Necessities e.g. doctor (inelastic) and Luxuries e.g. sailboat
(elastic)
•Market –narrowly defined markets have elastic demand (close
substitutes .e.g. ice cream), broadly defined market have inelastic
demand (no substitute .e.g. food)
•Time Horizon – over the long time horizons goods are more
elastic e.g. gasoline P increase, demand decreases for few months-
purchase efficient cars, e.g. electricity and energy savers in
Pakistan.

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The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic if:
• larger number of close substitutes.
• the good is a luxury.
• the more narrowly defined the market.
• the longer the time period.

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Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as

the percentage change in the quantity
demanded divided by the percentage change in
price.
P ercen tag e ch an g e in q u an tity d em an d ed
P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice

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Computing the Price Elasticity of Demand

P ercen tag e ch an g e in qu an tity d em an ded

P rice elasticity o f d em an d =
P ercen tag e ch an g e in price

• Example: If the price of an ice cream cone

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:
( 10  8 )
1 0 0 20 %
10  2
( 2 .2 0  2 . 0 0 )
1 0 0 1 0 %
2 .0 0
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The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the change.
( Q 2  Q 1 ) / [( Q 2  Q 1 ) / 2 ]
P rice elasticity o f d em an d =
(P2  P1 ) / [( P2  P1 ) / 2 ]

Copyright © 2004 South-Western/Thomson Learning

The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint
formula, would be calculated as:
(1 0  8 )
(1 0  8 ) / 2 22%
  2 .3 2
( 2 . 2 0  2 .0 0 ) 9 .5 %
( 2 .0 0  2 .2 0 ) / 2
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The Variety of Demand Curves

• Inelastic Demand
• Quantity demanded does not respond strongly to
price changes.
• Price elasticity of demand is less than one.
• Elastic Demand
• Quantity demanded responds strongly to changes in
price.
• Price elasticity of demand is greater than one.

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Computing the Price Elasticity of Demand

(100 - 50)
(100  50)/2
ED 
(4.00 - 5.00)
Price (4.00  5.00)/2
$5 P2  4, P1  5
4 Q2  100, Q1  50
Demand 67 percent
  -3
- 22 percent

0 50 100 Quantity
Do u know Demand is price elastic or
Inelastic here?
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The Variety of Demand Curves

• Perfectly Inelastic
• Quantity demanded does not respond to price changes.
• Perfectly Elastic
• Quantity demanded changes infinitely with any change in
price.
• Unit Elastic
• Quantity demanded changes by the same percentage as the
price
• Inelastic Demand: Elasticity less than 1
• Elastic demand: Elasticity is greater than 1
• Flatter curve Elastic and Steeper curve inelastic

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Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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 Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

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 Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

 Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
Total Revenue and the Price Elasticity of
Demand
• Total revenue is the amount paid by buyers and
received by sellers of a good.
• Computed as the price of the good times the
quantity sold. TR = P x Q

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 Figure 2 Total Revenue

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
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Elasticity and Total Revenue along a Linear
Demand Curve
• When demand is inelastic , an increase in
price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue
increases.
• Price and revenue move in a same direction

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 Figure 3 How Total Revenue Changes When Price
Changes: Inelastic Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

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Elasticity and Total Revenue along a Linear
Demand Curve
• When demand is elastic, an increase in the
price leads to a decrease in quantity demanded
that is proportionately larger. Thus, total
revenue decreases.
• Price and total revenue move in opposite
direction

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 Figure 4 How Total Revenue Changes When Price
Changes: Elastic Demand

Price Price

An Increase in price from $4 … leads to an decrease in

to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

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Linear Demand Curve

Slope of Linear Demand

curve is constant because
for each unit rise in price
2 units increase in Q
demanded but its
elasticity is not constant
because
Slope (rise over run) =
ratio of changes in two
variables but
Elasticity= ratio of %
changes in two variables

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Elasticity of a Linear Demand Curve
(Assignment)

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Income Elasticity of Demand

• Income elasticity of demand: measures the

quantity demanded of a good in response to
change in consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
P ercen tag e ch ang e
in q u antity d em and ed
In co m e elasticity o f d em an d =
P ercen tag e ch ang e
in in co m e
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Income Elasticity

• Types of Goods
• Normal Goods (+ve Income Elasticities i.e. greater
than zero and less than 1)
• Inferior Goods (-ve Income Elasticities i.e. less than
1)
• Luxurious goods (Income Elasticities always
greater than 1)
• Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.
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Income Elasticity

• Necessities tend to be income inelastic

• Examples include food, fuel, clothing, utilities, and
medical services.
• luxuries tend to be income elastic.
• Examples include sports cars, furs, and expensive
foods.

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 Cross Price Elasticity of Demand
(Related Goods)
• The response of quantity demanded of one good to change in
price of another good. OR
• Percentage change in quantity demanded of one good due to
change in price of its related good
Cross Price Elasticity of Demand= % change in quantity demanded of good 1
% change in quantity demanded of good 2

• e.g. in case of Substitutes: cross price elasticity of demand is

+ve. ( for example- Coke and Pepsi)
• But in case of complements: cross price elasticity of demand is
–ve. (For example computers and softwares)

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 THE ELASTICITY OF SUPPLY
• The responsiveness of supply to its determinants
• Price elasticity of supply: is a measure of how much
the quantity supplied of a good responds to a change in
the price of that good.
• Supply of a good is said to be elastic if it substantially
respond to changes in its price.
• Price elasticity of supply is the percentage change in
quantity supplied resulting from a percent change in
price.

Copyright © 2004 South-Western/Thomson Learning

Figure 6 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

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Figure 6 The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

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Figure 6 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

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Figure 6 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply

$5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

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Figure 6 The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.

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Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the

good they produce.
• Beach-front land is inelastic.( As it can’t be change)
• Books, cars, or manufactured goods are elastic.
• Time period.
• Supply is more elastic in the long run.

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Computing the Price Elasticity of Supply
(your reading Assignment)
• The price elasticity of supply is computed as
the percentage change in the quantity supplied
divided by the percentage change in price.
P ercentag e chang e
in qu an tity sup p lied
P rice elasticity o f sup p ly =
P ercen tage chang e in price

• Mid point Formula is also preferred in case of

price elasticity of supply, too.

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 APPLICATION of ELASTICITY

• Can good news for farming be bad news for

farmers?
• What happens to wheat farmers and the market
for wheat when university agronomists discover
a new wheat hybrid that is more productive
than existing varieties?

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 THE APPLICATION OF SUPPLY,
DEMAND, AND ELASTICITY
• Examine whether the supply or demand curve
shifts.
• Determine the direction of the shift of the
curve.
• Use the supply-and-demand diagram to see
how the market equilibrium changes.

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Figure 8 An Increase in Supply in the Market for Wheat

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
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Compute the Price Elasticity of Supply

1 0 0 1 1 0
(1 0 0  1 1 0 ) / 2
ED 
3 .0 0  2 .0 0
( 3 .0 0  2 . 0 0 ) / 2

0 .0 9 5
  0 .2 4
0 .4 Supply is inelastic
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